Tuesday, May 3, 2016

Feels More Like 2007 Than 1997?

The dollar slid to its lowest against major currencies in well over a year on Tuesday, a move led by further gains in the yen that threw an uncomfortable spotlight on central banks' attempts to boost growth through aggressive policy easing.

Australia's central bank joined the growing line of those adding stimulus, surprising many investors by cutting interest rates to a record low of 1.75 percent. That hit the currency but lifting the country's shares.

Almost every other major stock market around the world fell. MSCI's broadest index of Asia-Pacific shares outside Japan hit a three-week low, Europe's major indices shed as much as 2 percent and emerging market stocks fell 1.2 percent.

U.S. futures pointed to a fall of almost 1 percent at the open on Wall Street.

European financials fell more than 3 percent, hit by a string of weak first quarter earnings reports from banks and the euro's burst EUR= to an eight-month high above $1.16. European bank stocks are down more than 20 percent so far this year.

Shares in German lender Commerzbank fell almost 10 percent after profits slumped in the first quarter.

"The numbers for the first quarter did not come in well ... however external factors that have also hit other banks hard appear to be the main reason for that," said Landesbank Baden-Wuerttemberg analyst Ingo Frommen.

Shares in Swiss bank UBS were down 8 percent, also after first quarter results.

Europe's FTSE 300 index of leading 300 shares and Germany's DAX shed almost 2 percent, both falling to their lowest in nearly three weeks.

In currency markets the yen rallied towards 105 per dollar, its highest in 18 months.

It was as low as 122 a few months ago, and the sharp gains since will do nothing to relieve deflationary pressures in Japan.The dollar index .DXY, a measure of the dollar's value against a basket of major currencies, fell to 92.00. It was last there in January 2015.

The yen has accelerated its ascent since the Bank of Japan surprised markets last week by keeping monetary policy unchanged in the face of growing headwinds for its economy.

U.S. YIELDS FALL

Japan is in the middle of its Golden Week series of holidays. Markets were closed on Friday and will be closed from Tuesday to Thursday this week.

In Australia, stock markets cheered the rate cut with the benchmark index easily the outperformer in Asia and extending gains to close up more than 2 percent on the day.

The Australian dollar dropped sharply, falling below 0.76 against the greenback from 0.77 earlier.

Bond yields fell across the board, with the fall in U.S. Treasury yields outpacing the decline in European yields. The U.S. curve was down as much as 6 basis points, and the benchmark 10-year yield was at 1.81 percent.

After raising interest rates in December for the first time in nearly a decade, the Federal Reserve held monetary policy steady last week. While it kept the door open to a hike in June, it gave no signal that it was in a hurry to tighten further given the economy's slowdown, even as the labor market has improved.

"The Fed still thinks growth will be just over 2 percent this year but, on the evidence of Q1, it seems more likely that the euro zone will scale 2 percent, not the U.S.," said Steve Barrow, head of G10 strategy at Standard bank.

"The upshot is that market expectations for U.S. growth might be too high – as investors take their cue from the Fed's forecasts – while those for the euro zone are too low."

Crude oil prices lost ground, with U.S. crude futures down 1 percent at $44.32 a barrel.

At this writing, there are some big currency moves going on (click on images):

This is especially true after China and India recorded declines in their respective PMIs last month, showing a slowdown in manufacturing activity. And if we get another Big Bang out of China, you can be sure global risk assets will get clobbered and the deflation tsunami might hit North America next year (it's already hitting Australia, keep shorting the Aussie).

In Europe, things aren't much better. As I explained on Friday, all attempts by monetary authorities to resurrect global inflation have thus far failed miserably. This is why you're seeing the yen and euro strengthen relative to the USD. Global investors are worried that the Bank of Japan and the European Central Bank are way behind the deflation curve and that inflation expectations there will keep dropping.

And what happens when the yen and euro strengthen relative to the greenback and other currencies? It pushes import prices down, exacerbating deflation in these regions. This is not something that can go on indefinitely. At one point, monetary authorities are going to have to intervene to ease tighter financial conditions coming from a rising currency.

That's why I put those charts of the euro and yen relative to the USD. They are both at important technical levels. If they keep rising relative to the USD, it will reinforce deflationary pressures in Asia and Europe, all but ensuring weaker global growth in the second half of the year.

The U.S. government is sending a message to countries it believes are manipulating their currencies: We're watching you.

A Treasury report targets five countries in particular: China, Japan, Korea, Taiwan and Germany. Each meets at least two of the three criteria that "determine whether an economy may be pursuing foreign exchange policies that could give it an unfair competitive advantage against the United States."

At a time when currency devaluation has become a major tool used by multiple countries to stimulate growth, the U.S. is looking to protect its own interests. The report is an outgrowth of the Trade Facilitation and Trade Enforcement Act of 2015, a bipartisan effort aimed at stemming the global race to the bottom.

The criteria to determine whether a country should be on the "Monitoring List" of countries using unfair currency practices are: a trade surplus of larger than $20 billion, or 0.1 percent of U.S. GDP; a trade surplus with the U.S. that is more than 3 percent of that country's GDP; "persistent one-sided intervention," defined as purchases of foreign currency amounting to more than 2 percent of the country's GDP in a one-year period.

No country meets all three criteria, according to the report, though the five on the list meet at least two.

The act directs the president to engage each individual country on the list and tell it "to adopt appropriate policies to correct its undervaluation and external surpluses." If the countries in question do not act, the president can enact a variety of penalties, including cutting off the offending countries from Overseas Private Investment Corp. funding; asking the International Monetary Fund, which is charged with preventing currency manipulation, to step in; or reconsider whether the offending country should be engaged in trade agreements.

China came under harsh criticism when it devalued in August. The Treasury report notes China has "intervened heavily" in forex markets, and the issue has become political as well, with Republican presidential front-runner Donald Trump frequently bemoaning China's undercutting of the U.S. dollar.

To be sure, the U.S. could find itself in a tenuous position due to its own monetary practices.

Quantitative easing became popular on a global scale after the Federal Reserve enacted three rounds of QE that ballooned its balance sheet to $4.5 trillion. The dollar index, which measures the greenback against a basket of global currencies, declined as much as 18 percent peak-to-trough during the easing program, and has gained about 16 percent since the third round ended in October 2014.

The declining dollar was seen as a boost to multinational companies, while the post-QE strength has seen corporate earnings tumble and on track to decline about 7.6 percent in the first quarter, according to FactSet.

Treasury authorities see the dollar as a target from other countries whose growth has not matched that of the U.S.

"Concern that growth is decelerating in emerging markets has resulted in large capital outflows from these economies and downward pressure on their currencies," the report said. "The relative strength of the U.S. economy has pushed the dollar stronger against many currencies and on a trade-weighted basis over the past year and a half."

The report called on countries to implement more organic growth policies instead of simply seeking currency devaluation.

"More policy action is needed globally to strengthen demand," the report said. "Monetary policy responses have been forceful in general, but they need to be supported with additional fiscal actions to deliver a stronger boost to domestic demand."

Remember this is the Obama Administration publishing this report, not the Trump or Clinton Administration.

I'm not sure what to make of this report because right now, the only game in town is monetary policy and everyone is desperately trying to avoid a prolonged debt deflation cycle by manipulating their currency, including the United States, so it's highly hypocritical of them to warn others since they're also playing the currency manipulation game (when rates are at zero or negative, manipulating currencies is the only option to ease financial conditions).

Are we on the cusp of a global currency war? No, at least not yet. My friend who trades currencies told my readers that the U.S. leads the world by six months. In other words, the decline in the US dollar index (DXY) isn't sustainable and we can expect to see a reversal in the second half of the year, and perhaps sooner as signs of global weakness emerge.

I bring this up because I think too many people are NOT reading the macro environment properly and what this means for risk assets going forward.

Let me be crystal clear, a lot of the moves we've seen in risk assets from mid January till now are all related to the weakness in the US dollar, nothing else.

And by risk assets, I mean emerging market bonds and commodities, commodity currencies like the loonie, the Aussie, the Kiwi, oil futures, high yield bonds (HYG) which benefited from the rise in oil prices, and various cyclical stock sectors like energy (XLE), metals and mining (XME), industrials (XLI) and emerging markets (EEM).

Interestingly, despite weakness in the USD, a lot of these cyclical stock sectors are getting clobbered on Tuesday as are stocks tied to global growth (click on images):

Two points worth noting here:

No doubt, a lot of these sectors and stocks ran up a lot since mid January so it's not surprising to see profit taking and a correction

But yields on long term U.S. notes (TLT) are also declining on Tuesday as the 10-year yield fell to 1.79%. Clearly the bond market isn't worried about inflation, it's fearing global deflation and another global crisis.

Gold is enjoying an incredible year, surging 22 percent as the S&P 500 is barely positive. What's rare is for the yellow metal to outperform the market so dramatically in a year when stocks are up.

In fact, going back to 1980, there has been only year in which gold has outperformed the S&P by 20 percent or more while the latter was positive on the year: 2007.

Both gold and the fear-measuring CBOE Volatility Index surged in the second half of that year, even as stocks maintained their footing. The crash, of course, came in 2008.

Of course, the performance of the equity market cannot be predicted based on a single data point (or an infinite number of them, most likely). And there is still a lot of year left in 2016. Still, the potential propensity for gold to sniff out bad news earlier has some investors feeling less sure about holding stocks.

"Fear about a lot of really negative news flow is probably driving people into gold, even though it's not driving people out of the equity market for now," Manhattan Venture Partners' chief economist, Max Wolff, said Friday on CNBC's "Power Lunch."

"That makes us nervous and makes us look at gold" as a potential investment, Wolff said.

The falling dollar has probably contributed a good deal to gold's rise, given that the two assets frequently move inversely. In addition, some speculate that gold's incredible drop over the past few years has dragged gold prices too far down, making the metal a bargain at the year's outset.

Still, gold appears to be telling a story about investor sentiment, at least in part. And that might be a source of concern to those who keep a close eye on investor behavior — or on recent market history.

I don't read too much into gold's spectacular swing this year because for me, it's related to the weakness in the USD, not some supposed loss of confidence in central banks or that the world is coming to end (that's the type of nonsense Zero Hedge feeds its readers every single day).

Why am I so confident it's related to the USD? Because I've seen spectacular moves in steel stocks like Olympic steel (ZEUS) and US Steel (X) this year (both are getting clobbered today) and this has nothing to do with the loss of confidence in central banks. It's all about the weaker USD, period.

Right now, I'm much more scared of another 1997 than 2007. A lot of investors who jumped on the latest rally in cyclical stocks in the last month are going to get clobbered in the second half of the year, especially if Soros turns out to be right on China. That will all but ensure the Great Crash of 2016 which we escaped earlier this year will come back in play later this year (not saying it will happen during an US election year but never say never!).

Below, after the major averages kicked off May with their best daily gains in nearly three weeks, futures were pointing to a reversal after Australia’s central bank cut interest rates to an all-time low.

Also, Jim Rickards says for gold prices will go higher as the dollar weakens. I disagree and think the USD will revert back up in the second half of the year which is why I would take profits now and short all risk assets, including gold, which benefited from USD weakness thus far this year.

Third, FMHR traders discuss the new China opportunities fund from Hayman Capital's Kyle Bass. I trust Soros more than Bass when it comes to making serious money betting against China, so I wouldn't invest in his new fund (to be fair, I need to see details on lock-up and structure).

Lastly, former Greek finance minister Yanis Varoufakis, author of And the Weak Suffer What They Must?,
has some strong opinions when it comes to identifying what the single
greatest threat is to the global economy. He explains how it could create a major crisis. Listen to his views here. I'm far more worried about Japan, China and emerging Asia than Europe right now.

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